DEV 501: THE THEORY OF CONSUMER CHOICE Sakib-Bin-Amin Department of Economics North South University

THE THEORY OF CONSUMER CHOICE DEV 503: Economic Analysis for Development Practitioners THE THEORY OF CONSUMER CHOICE Sakib B. Amin, Ph.D. Assistant Professor School of Business and Economics North South University

Utility There are many goods and the consumer chooses a bundle (or combination) of quantities. Here we simplify to two goods, good X and good Y. Goods yield satisfaction to the consumer; we shall call it ‘utility’. Utility is the benefit or satisfaction that a person gets from the consumption of a good or service. Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Cardinal vs. Ordinal Utility In economics utility can Cardinal or Ordinal. Utility is a subjective quantity that can not be measured in an obvious way. People usually attempt to maximize welfare or utility, the enjoyment or satisfaction that they derive from the consumption of a commodity or service. A utility is a cardinal measure if we can give numbers to different levels of utility AND if we can make absolute comparisons between those different numbers. Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Cardinal vs. Ordinal Utility For example, if the utility you get from a bundle is 100 while the utility you get from another bundle is 50, you can say that the first bundle gives you more utility than the second AND you can also say that the first bundle gives you double utility compared to the second. A utility is an ordinal measure if only the ranking between different bundle matters. We cannot make absolute comparisons. From previous example, we can only say that the first bundle is preferred to the second because the utility associated with the first bundle is higher than the utility associated with the second bundle. And that’s all. The differences in utilities (100 – 50) has no other meaning. Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Cardinal vs. Ordinal Utility We normally consider utility to be ordinal. The main reason is that to have a cardinal utility we must have a unit of measure that we can use to measure utility. However, as you may guess is not very easy to find such a unit of measure (for example, how do we measure happiness? We can say if we are happier in some cases than in others, but we cannot really say more than that). According to Bentham and Marshall, utility can be measured- if not in practice, at least in principle- with cardinal numbers ( such as 1,2,3 and so on). This cardinal measure of utility is commonly known as UTIL. Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Utility Function The Important concept is that any consumer can rationally compare and rank different combinations in terms of utility. (This is what we mean by preference). Utility function can be written as: U(x, y) Consider two different bundles (x1, y1) and (x2, y2), and assume that our consumer prefers (x2, y2) to (x1, y1) then we must have that: U(x1, y1) ›U(x2, y2) Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Total Utility Total utility is the total benefit that a person gets from the consumption of a good or service. Total utility generally increases as the quantity consumed of a good increases. Total Utility Increases at a decreasing rate. Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Marginal Utility Marginal utility is the change in total utility that results from a one-unit increase in the quantity of a good consumed. To calculate marginal utility, we use the total utility numbers in Table. Suppose that you can consume 30 units of good A and 20 units of good B. You get some utility in doing that. Now assume that you can consume 31 units of good A and 20 units of good B. Your utility will probably change. This change in utility is the marginal utility of good A. Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Total and Marginal Utility Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Total and Marginal Utility The marginal utility of the 3rd bottle of water = 36 units – 27 units = 9 units. Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Part (b) shows how Tina’s marginal utility from bottled water diminishes by placing the bars shown in part (a) side by side as a series of declining steps. The downward sloping blue line is Tina’s marginal utility curve.

Diminishing Marginal Utility The law of diminishing Marginal Utility states that for a given time period, the marginal utility gained by consuming equal successive units of a good will decline as the amount consumed increases. Even though marginal utility declines, total utility still increases as long as marginal utility is positive. Total utility will decline only if marginal utility is negative. Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Diamond-water paradox As noted by Adam Smith, water is essential for life and has a low market price (often a price of zero) while diamonds are not as essential yet have a very high market price. Smith’s observation came to be known as the Diamond- Water Paradox. Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Diamond-water paradox If a product is very useful then Total Utility of the product is very high compared to a less useful product. That Means value in use is related to total utility. The total utility of water is high because water is extremely useful but we would expect its marginal utility to be low because water is relatively plentiful. Water is immensely useful, but there is so much of it that individuals place relatively little value on another unit of it. Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Diamond-water paradox In contrast, diamonds are not as useful as water. We would expect the total utility of diamonds to be lower than the total utility of water. However, we would expect the marginal utility of diamonds to be high because there are relatively few diamonds in the world. So the consumption of diamonds takes place at relatively high marginal utility. Generally, Value in exchange is related to marginal utility that means Market price is based on the Marginal Utility concept. If Marginal Utility is high, the Market Price is also high and vice versa. Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

TU of water and diamonds Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

MU of water and diamonds Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Equimarginal Principle Equimarginal principle states that a consumer having a fixed income and facing given market prices of goods will achieve maximum satisfaction or utility when the marginal Utility of the last dollar spent on each good is exactly the same as the Marginal Utility of the last dollar spent on any other good. MU Good1/P1 = MU Good2/P2= MU Good3/P3=………… In other words, MUX/PX=MUY/PY If any one good gave more MU/Dollar, utility would be increased by taking more money away from other goods and spending more on that good- until the law of diminishing MU/Dollar down to equality with that of other goods. Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Equimarginal Principle Case 1: MUX/PX>MUY/PY In this case equilibrium will be achieved by increasing the amount of Product X. Case 2: MUX/PX<MUY/PY In this case equilibrium will be restored by decreasing the amount of Product X. Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Why Demand Curves Slope Downward? Using the fundamental rule for consumer behaviour, we can easily see why demand curves slope downward. Let us assume, The price of X falls. The situation now becomes: MUX/PX>MUY/PY The consumer will attempt to restore equilibrium by buying more X. This behaviour- buying more X when the price of X falls- is consistent with the law of demand. Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Indifference Curve Features: Indifference Curve is a curve which shows the different combinations of two commodities that gives the consumer same level of utility. Features: Utility is same on each point of indifference curve. Indifference curve shows consumers’ preference. Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

INDIFFERENCE SCHEDULE Indifference Curve INDIFFERENCE SCHEDULE Combinations Apples Mangoes 1 15 2 11 3 8 4 6 5 Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Indifference Curve In the above schedule, the consumer obtains as much total satisfaction from 11 apples and 2 mangoes as from 8 apples and 3 mangoes as well as from other combinations. In other words, consumer feels indifferent whether he gets the 1st combination (15A+1M), 2nd combination (11A+2M), the 3rd combination (8A+3M), the 4th combination (6A+4M), or the 5th combination (5A+5M) Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Indifference Curve Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Indifference Map A set of indifference curve is called an indifference map. A higher indifference curve give higher utility but we can’t say how much more utility the higher indifference curve represents. Aggregate Utilities are remarkable but not measurable. Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Indifference Map Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Marginal Rate of Substitution The Marginal rate of substitution shows how much of one commodity is substituted for how much of another or at what rate a consumer is willing to substitute one commodity for another in his consumption pattern to maintain the same level of utility. The concept of MRS is a tool of Indifference Curve technique and MRS is the slope of Indifference Curve. In the previous example, we have noticed that when a consumer has 15 Apples and 1 mango, he will be prepared to forgo 4 apples for 1 mango and yet remain at the same level of utility. Here the MRS of Mango for apple is 4:1 MRS=∆Y/ ∆X= Slope of Indifference Curve Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Consumer Equilibrium This is the Consumer Equilibrium Condition A consumer attempts to allocate its limited income among available goods and services so that he can maximize his satisfaction or utility. Consumer equilibrium comes at the point where consumer utility is maximum. This occurs at a point where the budget line is tangent to the indifference curve. At this point of tangency: Slope of Indifference Curve = Slope of Budget Line MRSXY=PX/PY MUX/MUY=PX/PY MUX/PX=MUY/PY This is the Consumer Equilibrium Condition Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Consumer Equilibrium If MUX/PX>MUY/PY, it indicates that we have to purchase more X commodity. It will cause the MU to fall and over time equilibrium condition will be restored. If MUX/PX<MUY/PY. It indicates to consume less. Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Consumer Equilibrium Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.